Follow The Herd In Trading The Capital Market

If you have ever heard “the trend is your friend” and believed it, you may be a fan of herd instinct mentality. This is an environment where, just like with fashion, masses of people follow a pattern that the majority of people around them are following … sometimes for no sensible reason. This mentality can be driven by greed, excitement or even the fear of missing out on an opportunity to make huge returns, and many times this thinking is not driven by a logical fundamental investment process. Herd investing is not for the staunch contrarian - those who believe the market is efficient or that current valuations or market conditions reflect a sensible response. Fortunes can be made or lost on the edge of a dime as masses driving an investment or group of investments for no obvious material reason. The downside to being on the wrong side of the herd can be disastrous, as markets swoon and crash … you don’t want to be the one left holding the bag.

Herding and CurrenciesWhile herd investing can be found in just about every asset class - equities, bonds, commodities etc. - it is most commonly used in currency trading. This is for a few reasons:

1. Currency markets are some of the largest, most liquid markets in the world towering over some asset classes with trading totaling in the trillions per day.2. Currency trading, unlike other asset classes, bases most of its movements on technical indicators versus true currency valuations, creating a fertile environment for herd trading.3. While afterhours trading has grown for traditional asset classes, currency trading virtually never stops. Herd trading in currencies can start with a small group and expand quickly due to the number of traders around the globe jumping in on a trend to increase its strength and push trades far beyond what would be a reasonable level, as the more one-sided the trades the stronger the gains. Just like with any other trading strategy, knowing when to take profits and find the next herd is key.

Classic Tale of HerdingCurrency trading does not get as much press as more traditional asset classes that now receive attention by the minute from TV and Internet reporting and more recently from social media. One of the first media-driven herd events was the dot-com bubble, which started in the latter part of the 1990s after a strong run in traditional equities. This bubble was a classic example of herd following which created billionaires overnight and there was plenty of room for the small investor to grab and hold on and came to an abrupt end mid-March 2000. This was also the early days of CNBC becoming a mainstream option that could be seen on televisions all over town, stopping people in their tracks. New businesses popped up overnight or just added “.com” to their name and stocks soared as money chased every stock covered that day on CNBC or websites that started to pop up. The world was in love with the Internet and was willing to pay any price to be part of the club. Investors of all types threw caution to the wind and no longer considered this type of investing speculative; all they could see was infinite growth and the status of owning these stocks.

For those of you scoffing at the idea that only wild-eyed Internet crazed fans were in on this bubble, think again. If you owned just about any of the largest mutual funds in the late 1990s, your portfolio probably had over 20% dedicated to technology and your largest holdings may have been some of the largest technology giants in the world. Even an index fund that draws more conservative investors over time had large technology weightings, as they mirrored the underlying index bloated with technology and Internet stocks.

While traditional fundamental investors and contrarians stood on the sidelines, the herds formed and pushed the technology sector (and the overall market along the way).

Tossing aside traditional thinking and caution, jumping on this herd made investors very happy, which fueled a frenzy. Investors feasted on Companies like Amazon, Yahoo and any company associated with the exploding Internet. These were trying times for traditional conservative investment companies, many of which tossed in the towel late in the trend and introduced tech-related funds or increased their tech weightings. This was mostly driven by clients who were insisting that they were missing the boat. This is where lifelong lessons were learned. Signs began appearing that this trend was slowing, as there is only a finite amount of capital to follow along the herd. For those who started early and took profits along the way, they correctly followed the herd and won. For those who jumped in late with little knowledge besides what their taxi cab driver had recommended, many lost small fortunes.

Applying the Herd StrategyIf you do like to follow the herd for all or a portion of your investing, you will have to have at least some basic trading skills. There are more tools at investors’ hands than the typical mutual fund from 15 years ago, such as ETFs that trade like stocks.

If you are following a herd, market buy orders might be the best way to enter into a stock or fund. For the savvy trader, understanding the bid/ask spread, volume and liquidity can add incremental value to each trade, which adds up over time. As mentioned, the currency market has very thin bid/ask spreads (the difference between the price buyers are willing to pay versus the price sellers are willing to sell) due to the high volume and liquidity. Large stocks like IBM typically have a $0.01 to $0.03 spread and market orders are efficiently executed every day at the NYSE, which uses specialists to match trades and ensure flow and liquidity. A company like Apple with average volume of over $4 million shares daily may have a $.05 plus bid/ask spread at a given time. If you are following a herd and need to buy into a stock, a market order will ensure your order will execute at the current ask price. If the stock pulls back, you will have paid a premium, but if the stock continues to rise, this may not be a bad trade if the herd was also chasing the price up.

For more detailed price information, Level II quote access provides deeper insight into what the herd is up to for Nasdaq traded stocks. If you are attempting to trade with the herd, Level II quote access is needed to see the depth of trading and can be accessed for a monthly fee. Orders are placed from many sources from multiple market makers or ECN’s (electronic communications networks) and Level II gives you access to where the matching happens in a fraction of a second. An example of a screen shot of a bid at Level II:

Source: Bloomberg

Four-letter indicators market the interest to buy or sell securities in real time then matched as indicated in yellow.

Bottom LineHerd investing is a relatively new concept that has grown exponentially with the help of the media and the Internet. While investors relied on their traditional brokers for quotes 30 years ago, they now have instant access in the palm of their hands. There are many reasons investors large and small follow herds, including just to be part of the in-crowd, knowing full well that they are simply gambling. Herds are found in currency trading, commodities and individual securities, each with their own pricing sources and trading techniques. For those with the time, trading expertise and the ability to blindly follow and exit rapidly, this can be a valid portion of their overall investment portfolio.